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In 1999, Harry Markopolos, a derivatives portfolio manager at Rampart Investment Management in Boston, was asked to replicate Bernie Madoff's 'split-strike conversion' strategy. He concluded within hours that the returns were impossible. Madoff confessed in December 2008 to a fraud with roughly $65 billion in reported account balances, which set up Markopolos's February 2009 congressional testimony against the SEC.
A claimed strategy can be falsified by comparing the trading volume it would require against the size of the market it trades in. To hedge the assets Madoff claimed to manage with S&P 100 index options, he would have needed more contracts than existed on the exchanges, and counterparties would have noticed flows of that size. When the market the strategy depends on is too small to hold it, the trades cannot be happening.
Any real strategy leaves a statistical signature that its reported returns must match. A collar on a basket of large-cap stocks should track the stock market, with losing months when the market falls. Madoff reported about 1% a month, very few down months, and near-zero correlation with the S&P 100, which means the numbers could not have come from the instruments he said he traded.
Markopolos argues the SEC missed the fraud because its examiners were mostly lawyers and accountants who could not follow a derivatives-based mathematical proof. Unable to judge the evidence themselves, they fell back on Madoff's standing as a former NASDAQ chairman and checked only the paperwork he chose to show them. When an oversight body lacks the expertise its task requires, the reputation of the person being examined replaces verification.